A Serious Fraud Office investigation into Kaupthing, the failed Icelandic bank, is understood to be pursuing a number of allegations of market manipulation involving investment vehicles controlled by some of the bank's largest clients, including several high profile UK business leaders.

It is alleged that in the weeks and months before Iceland's financial system went into meltdown, certain trades improperly used at least €500m (£413m) of Kaupthing funds in an effort to manipulate credit derivatives. Bank bosses hoped this would restore crumbling confidence in Kaupthing's solvency in the months before the bank collapsed in October 2008.

The SFO, which announced a wide-ranging probe into Kaupthing last December, is believed to be closely scrutinising the role of Deutsche Bank, which is said to have been advising Kaupthing throughout 2008 and allegedly played a role in facilitating suspect trades. Investigators want to establish whether or not Deutsche Bank or its employees may have acted improperly by pushing trades through.

A spokesperson for Deutsche Bank said: "We are co-operating with the authorities in seeking to establish the facts in this matter." The bank declined to comment on details of the allegations.

Also caught up in the investigation is Conservative party donor Tony Yerolemou, who is the London-based food manufacturing entrepreneur behind the Cypressa food brand. Others who have become embroiled in the saga include high street fashion entrepreneur Kevin Stanford and his former wife Karen Millen.

There is no suggestion of dishonesty on the part of Stanford, Millen or Yerolemou, all of whom had close ties to Kaupthing – the latter being a non-executive director at the bank. They are not thought to have known the trades might amount to market abuse on the part of Kaupthing.

Working closely with Icelandic counterparts and the Financial Services Authority, the SFO is focused on offshore investment vehicles, nominally controlled by at least five of the bank's largest clients, including the three British entrepreneurs. Investigators are looking at whether these vehicles were used by Kaupthing executives to manipulate the price of certain derivatives that offered insurance against Kaupthing bonds defaulting.

In the credit derivatives market the price for insuring these bonds against the possibility of the bank going bust had been climbing sharply for certain periods in 2008, sparking wider concern about Kaupthing's solvency. Bank executives were desperate to reverse rising insurance premiums as these were increasingly being highlighted as a warning light flashing over the bank, damaging investor and depositor confidence.

However, the bank could not act alone. Clearly Kaupthing could not offer to insure against its own insolvency because, in such an event, it would not have the funds to pay out on the insurance policy. Instead Icelandic bank bosses arranged for loans to be extended to investment vehicles controlled by trusted Kaupthing clients and these sums were used to write the insurance contracts, known as credit default swaps (CDSs).

Investigators are poring over communications between Deutsche Bank and senior figures at the Icelandic bank, including London-based former executive chairman Sigurdur Einarsson and former chief executive Hreidar Mar Sigurdsson.

Both Einarsson and Sigurdsson deny wrongdoing. The former Kaupthing chairman has insisted the CDS trades under investigation were Deutsche Bank's idea – a claim the German bank is understood to deny strongly.

A letter from Einarsson, containing his explanation of the CDS trading strategy, was leaked to the Icelandic media last year. In it he said: "On a proposal from Deutsche Bank it was decided to put to the test what would happen if the bank itself would start buying these credit default swaps. It was, however, not a simple issue, as the bank cannot buy credit default swaps on itself. Therefore [we] resorted to getting clients we trusted well and had long-standing relations with based on trust and loyalty to engage in these transactions on behalf of the bank … The transactions were made with the interests of the bank as a guiding light and fully in accordance with laws and regulations."

The effect was for investment vehicles – financed by Kaupthing loans, and at least nominally controlled by some of the bank's largest clients – to take on risk associated with the bank going bust. Kaupthing loans were being use to write insurance against Kaupthing bonds defaulting.

A 2,300-page Truth Commission report for the Icelandic parliament, published in April, said: "In the fall of 2008, Kaupthing ... loaned its key clients roughly €500m for the purpose of selling credit default swaps on Kaupthing itself. The clients themselves took no risks but they would have made substantial profits if the bank would have withstood ... difficulties."

It added: "By selling these CDSs the bank was in a way paying up its long-term debts. The buyer of these credit default swaps, on the other hand, was Deutsche Bank or its foreign clients. Yet again had an Icelandic bank bought a foreign bank out of Icelandic risk troubles, and the loans and the risk had been repatriated."

One source said it was unclear whether Deutsche Bank employees had been fully aware of the relationship between the investment vehicles that conducted the CDS trades, on the one hand, and Kaupthing, on the other.

Deutsche Bank has emerged as the largest single claimant against the assets of failed Kaupthing and is said to be owed almost 900bn Icelandic Krona (£4.8bn) through close to 50 different claims. The bulk of that sum is understood to relate to claims in Deutsche Bank's capacity as custodian bank on behalf of third parties.

Iceland's Truth Commission obtained details of emails sent by Deutsche Bank staff to Kaupthing which, according to its report, demonstrated that the German bank had been offering advice on how to influence the CDS price on Kaupthing bonds from early 2008. The Icelandic bank had become concerned because the price was indicating a relatively large and growing risk that Kaupthing could collapse – a risk assessment out of line with the more favourable scores from traditional credit rating agencies.

One memo in February 2008 from Deutsche Bank to Kaupthing was entitled: "Why the CDS curve is where it is and what can we do to take it back to normal levels". A second Deutsche Bank email in June allegedly discussed the idea of a trade in Kaupthing derivatives. The Truth Commission report states that this email argued such a trade could be an effective way to affect the market price for Kaupthing CDSs. The email allegedly suggested the timing would be critical if it was to get "most bang for the buck".

Kaupthing bosses have said they believed the price for insuring against the bank going bust was being manipulated by hedge funds trying to "short" the bank. They said false rumours were circulating about the bank.

Kevin Stanford

Best known for co-founding retailer fashion chain Karen Millen, which took the name of his then wife and business partner, pictured right, Stanford is one of the most prolific entrepreneurs in UK high street fashion, involved in investments including All Saints, Mulberry, Moss Bros, Debenhams, French Connection and Woolworths. His relationship with the now failed Icelandic bank started in 2000 and Kaupthing took a stake in Karen Millen the following year. The business later merged with Oasis, a rival chain that had been acquired by Icelandic investment group Baugur together with Kaupthing. This combination became known as Mosaic Fashions and went on to acquire several other chains. Despite being separated, Stanford and Millen continued to regularly operate as silent backers of each other's investments. Stanford eventually became the second largest borrower from Kaupthing's subsidiary in Luxembourg, receiving loans of €362m. He is also said to have been granted a €100m loan from Kaupthing in Reykjavik to fund the acquisition of shares in the bank. In the last two years Stanford's investments have suffered and he has been forced to make major concessions to Kaupthing's administrators.

Tony Yerolemou

Co-founder and former chief executive of Katsouris Fresh Foods, a family run business in west London making ready meals and dips for Tesco and other supermarkets, The group includes the Cypressa brand, which had been built up over decades. He is best known in the UK as a Conservative donor. In 2001 Katsouris was sold to the tiny Icelandic firm Bakkavor, specialising in exporting fish roe. The family received £70m in cash and £32m in Bakkavor shares. Cyprus-born Yerolemou took a seat on the board of the Icelandic firm. Debt financing for the deal — at the time the largest ever for an Icelandic firm — had been provided by Kaupthing and HBOS. In 2007 Yerolemou was appointed to the board of Kaupthing as a non-executive director. Some of his investments were under strain in 2008 and the recent report by Iceland's Truth Commission suggested some of his business interests, financed by Kaupthing, appeared to be in negative equity. The commission's report questioned whether he met a "fit and proper" test required for him to sit on the bank's board. By the autumn of 2008 Yerolemou was the fourth largest borrower from Kaupthing's Luxembourg subsidiary, receiving loans of €157m. Like many clients of the Icelandic bank, he owned shares in it, which were pledged as collateral against Kaupthing loans.